Editor’s Note: This article was originally published on December 15, 2020 as a member’s only Advisor Update. It was made publicly-available on August 9, 2021.

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But I’d like to share with you a company that was considered for a 7investing recommendation — until my research uncovered a few serious red flags that made it too risky for an official recommendation. That company is Axsome Therapeutics (NASDAQ: AXSM).

Axsome Therapeutics is a development-stage pharmaceutical company focused on central nervous system disorders, such as depression, migraine, and Alzheimer’s disease agitation. Its simple, orally-administered drug candidates have potential commercial advantages and work through novel mechanisms of action, which are especially important in depressive disorders that have seen little innovation in recent decades. The company estimates combined peak annual sales potential for its drug candidates of at least $4 billion — not bad for a business valued at “only” $3 billion right now.

I’ve covered and held a relatively favorable opinion of Axsome Therapeutics since January 2019. The stock has gained over 800% since then. If the market potential for its pipeline becomes reality, then the company would be significantly undervalued at current levels.

So, what made me back off considering it for a recommendation? There were three specific red flags that have changed my opinion of the company:

1. Shareholder unfriendly licensing: Axsome Therapeutics CEO Dr. Herropt Taniteau owns the IP for several drug candidates, but assigned the patents to a paper company he owns called Antecip Bioventures. Axsome Therapeutics has to pay flat royalties on several drug candidates, including 3% of net sales for its lead drug candidate, to Antecip. This is not very shareholder friendly, although it works out great for the CEO. The arrangement can (and should) be terminated by Axsome Therapeutics, but this licensing agreement isn’t something CEOs and companies that are aligned with shareholders draw up in the first place.

2. Clinical trial design: The lead drug candidate, AXS-05, recently failed a clinical trial in treatment-resistant depression (TRD), so I looked into the reasons. As it turns out, Axsome Therapeutics actually designed the clinical trial to favor a positive outcome — and still couldn’t meet primary outcomes. Among other things, the company adopted a much more lax definition of TRD than the definition accepted by regulators. It’s also important to point out that the failed clinical trial compared AXS-05 to another compound with activity against depression, whereas the successful clinical trials to date have only compared the drug candidate to placebo. If favorable design of clinical trials or cherry-picked patient populations are true for other studies, then regulators can easily scrutinize these factors during or after approval.

3. Patent protections: A pipeline asset disappeared from the company’s pipeline in recent years, so I looked into the reasons. As it turns out, the intellectual property supporting AXS-02 was successfully challenged in court by Grunethal because the active pharmaceutical ingredients (API) were a simple combination of generic drug compounds. Simplicity was also one of the core advantages of the company’s approach, in my opinion, but now it seems this poses a major risk for investors. The lead drug candidate, AXS-05, is formulated in the same exact manner: Combining dextromethorphan (a common ingredient in cough syrup) and bupropion (a common smoking cessation drug). If the patents for AXS-05 are successfully challenged in a similar manner, then that could threaten the company’s estimate for $2.5 billion to $6 billion in peak annual sales for the asset across multiple indications.

Wall Street has a relatively favorable view of Axsome Therapeutics, but these three red flags aren’t widely reported. Outside of regulatory filings that most investors or financial writers don’t take the time to read, I could only find one other source mentioning, even in passing, any of these factors.

Can Axsome Therapeutics crush its market opportunity without stumbling over any of these potential pitfalls? Certainly, but these are the types of risks that sneak up on healthcare investors and lead to single-day, 50% (or more) drops in stock price that are difficult or impossible to recover from. Look up the stock chart of Amarin (NASDAQ: AMRN) for the most recent example of a high-flying stock being brought back to earth by things most investors overlooked, knowingly or unknowingly.

I’m by no means rooting for the company to fail. After all, Axsome Therapeutics has snagged multiple Breakthrough Therapy designations from regulators and is working to treat disorders with significant unmet need. I very much hope it succeeds from the standpoint of the public good.

I’m simply sharing with you part of my behind-the-scenes research process that uncovered a handful of red flags. All 7investing lead advisors put the companies up for consideration through a similar vetting process with in-depth research and frameworks that fit specific industries.

Considering I only make 12 recommendations in a calendar year, I don’t feel the need to overlook these risks because I might be able to claim a multibagger. There are better investments to make. In fact, I feel confident that my first three recommendations (all of my pharma and biopharma picks as of this writing) will outperform Axsome Therapeutics in the next five years. There’s only one way to find out.